As Warren Buffett once said, “Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

The concept of an investing edge and what it creates is fascinating. There is the so-called Behavioral Edge (taking a longer-term view than average investors and having the ability to tolerate price declines), the Analytical Edge (developing a different conclusion than that of the market) and the Informational Edge (focusing on deep primary research, recognizing factors overlooked by other investors, and leveraging our experience and industry relationships). At Townsend we want to develop all three.

Our edge is less about knowing more than everyone else about a specific stock and more about the mindset, the discipline, and the time horizon that we maintain as investors. Thinking long-term is a commonly talked about potential advantage but is one that is much less often acted upon. With the use of time, we try to gain a significant edge over other investors, who can be focused on short-term outcomes.

It is important to know that the investment profession is hyper-competitive and firms in the business of investing can be driven by the fear of underperforming their benchmarks. This affects their decision-making immensely and causes them to fixate on short-term factors that are unimportant relative to what makes for a good long-term investment. It also explains why many investors fixate on earnings, extrapolate recent earnings reports too far into the future, overreact to positive or negative news, and act as if recent price action will continue. This behavior is created by career worries since many professional investors are hired and fired based on their recent performance. But it is this very behavior that also creates long-term opportunities for patient investors and helps mitigate downside risk.

“We look for a horse with one chance in two of winning and which pays you three to one.” — Charlie Munger

The price of an investment says a lot about the future expectations that others are making about it. In fact, it is the price itself that makes every investment good or bad. Payoffs matter and risks matter. Good long-term investors take seriously the process of how investments should be valued, and what expectations are priced in. The factors that drive that value, and the fundamental changes to the investments themselves that will affect their long-term prices. It is the consensus of others that is reflected in the price, which is what makes investing a pari-mutuel activity.

In pari-mutuel betting, i.e., horse racing, money comes into a pool and sets the odds. But the odds that you see are not the actual probability of winning…just the crowd’s consensus perception of the horse’s prospects. The stated odds, i.e. 2:1, can be thought of as a ‘price’ that reflects expectations. That ‘price’ is set by the flow of money – buying and selling. The observed price of a stock reflects the odds of success (a return) because the difference between the observed price (as set by others’ expectations) and a stock’s true economic value (actual performance and cash flow of the business) will create your future return.

In a pari-mutuel system, bettors wager against one another. In fact, in French parier mutuel means “to wager among ourselves.” The goal in a pari-mutuel system is not necessarily to pick the winner – it is to pick the horse whose actual odds of winning are far better than the stated odds (the price). For example, rational bettors would put their money on a horse whose stated odds (and payoff) are 8:1, but whose actual odds are 5:1. One would make such a bet an infinite number of times even though one would lose 4 out of 5 times. The risk and the payoff are what make for a good or bad investment.

“It is remarkable how much a long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” — Charlie Munger

A ‘permanent loss of capital’ is an investment made in something that declines in price and will never recover. Future bankruptcies and overvalued stock are primary sources.

A primary goal of investing is to avoid costly mistakes because it is the bad investments not made that lower risk and contribute significantly to your portfolio’s return. And to avoid incurring a permanent loss means not overpaying for an investment. But besides not overpaying, it is of the utmost importance to read the footnotes in the financial statements, which is where many risks are disclosed but not highlighted. Investments can be complex because they require understanding the nature, economic value and endurance of the company’s asset base, as well as the quality, stewardship, incentives and culture of management and the board of directors. Are they acting in the shareholder’s best interest or their own? Sometimes great businesses are led by people who are more interested in treating themselves before their shareholder and partners.

We will be wrong more often than we expect – this is the nature of working with an uncertain future. Despite the best analysis and risk assessment, the investments we make still have risk and their outcomes will sometimes not be what we expect. Even well-compensated risks don’t work out, often because the future deviates significantly from what we expected. As such, sticking with positions as factors go against the companies in which we invest can be misplaced hope as opposed to an opportunity to cut losses and reinvest in something with better prospects.

These two quotes by the inimitable Peter Bernstein are worthy of consideration:

“If it’s true that you never get poor by taking a profit, it would follow that cutting your losses is also a good idea. But investors hate to take losses, because, tax considerations aside, a loss taken is an acknowledgment of error. Loss-aversion combined with ego leads investors to gamble by clinging to their mistakes in the fond hope that someday the market will vindicate their judgment and make them whole.”

“After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future. Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.”